Hedging exchange traded mutual funds or other portfolio basket products

ABSTRACT

A system for determining a basket of financial instruments for hedging investment risk in actively managed exchange traded funds is described. The system uses a trusted computer system and includes a computer storage medium storing a computer program product. The product determines the basket of hedging instruments by extracting factor information from a portfolio of the actively managed exchange traded fund and determining factors that affect the price of the exchange traded fund. The program can select a portfolio of instruments with similar behavior with respect to the determined factors to produce a hedging portfolio that tracks the price of the exchange traded fund.

BACKGROUND

This invention relates to hedging techniques for exchange traded fundsor similar basket products.

Exchange traded funds or basket products such as S&P 500 DepositoryReceipts (SPDRs) are vehicles for holding a basket of securities thatcan be traded on an exchange or securities market. More specifically,these instruments usually represent I an undivided ownership interest ina portfolio of stocks or other securities held by a Trust. The portfolioof stocks is often intended to track the performance of an index likethe S&P 500 Index, and therefore seeks to invest substantially all ofits assets in the stocks comprising the S&P 500 index, in proportion tothe relative weights of stocks in that index. SPDR shares are securitiesissued by the SPDR Trust and may be traded on a stock exchange or inover the counter transactions.

The intra-day pricing of such securities is determined by supply anddemand. Typically, these SPDR fund shares may be created or redeemed atthe end of each business day at a net asset value price in so called“creation units”. In the case of the SPDRs the creation unit has 50,000SPDR fund shares. SPDR creation units are created or redeemed at the endof day net asset value through an in-kind transfer of securitiescorresponding to the S&P 500 index. While the official net asset value(NAV) of the SPDR Trust is only published at the close of every businessday, the estimated value of the underlying S&P 500 index and the valueof the creation basket are published continuously throughout eachtrading day. The per SPDR value of the index and/or the creation basketcan be devised and distributed electronically to brokers, dealers, andinvestors throughout the world.

An intra-day value disseminated by the exchange is a real timecalculation designed to give an investor a per share price which is veryclose to what the intraday net asset value would be, if it werecalculated. At the end of trading, the intraday approximate calculationand the official NAV should be nearly identical.

Intraday values of exchange traded trusts such as SPDRs or mutual fundssuch as the Select Sector SPDRs may be evaluated from the publiclyavailable creation basket or the index on a per share basis throughoutthe day as if the creation basket or the index were the portfolio of thefund. The calculation is relatively straight forward, since the creationbasket composition changes little from day to day unless the indexchanges. While the fund may contain proportionately a few more shares ofone stock and a few less of another stock than would be provided bymultiplying the creation basket by the number of creation baskets thatconstitutes the fund, the calculation is very close to net asset value.

Trading on exchanges such as the America Stock Exchange involves atrader called a specialist. A specialist tries to match buy orders withsell orders in a manner that maintains an orderly market. Oftenspecialists and market makers (who make markets for securities onexchanges or on electronic markets such as The Nasdaq Stock Market andwho have obligations similar to but less demanding than those of thespecialists to help maintain an orderly market) will have to take acontrary position to the prevalent position in the market by placingtheir own capital at risk. In securities markets, during the course of atrading day, there can be a net demand for a security, e.g., an exchangetraded fund. Thus, over the course of a trading day, the specialist andany market makers trading the security can be selling more shares of asecurity than they are buying. In this situation, the specialist mightbuy components of the fund or derivatives based on the fund or on anunderlying index in order to hedge its position. If the specialists andmarket makers have bought more shares of a security than they have sold,they might sell short components of the fund or associated derivativesto hedge their positions.

SUMMARY

For actively managed exchange traded mutual funds the composition of thefund may not be known to the market maker or the specialist and hencehedging against a creation unit basket or an index such as the S&P 500may not be effective, since the fund may behave very differently thanthe creation unit basket or index. Since there is no correspondingsecurity or index or alternative fund with which the specialist ormarket maker can hedge a position, trading in such actively managedfunds is more difficult than trading a fund based on a known index.

According to an aspect of the present invention, a method of hedginginvestment risk in actively managed exchange traded funds includesextracting factor information from the portfolio of the actively managedexchange traded fund and determining factors that affect the price ofthe exchange traded fund. The method also includes selecting a portfolioof financial instruments with similar behavior with respect to thedetermined factors to produce a hedging portfolio that tracks the priceof the exchange traded fund.

According to an additional aspect of the present invention, a computerprogram product residing on a computer readable medium for hedginginvestment risk in actively, managed, exchange traded funds includesinstructions to extract factor information from a portfolio of theactively managed exchange traded fund, determine factors that affect theprice of the exchange traded fund and select a portfolio of financialinstruments with similar behavior with respect to the determined factorsto produce a hedging portfolio that tracks the price of the exchangetraded fund.

According to an additional aspect of the present invention, a computersystem for determining a basket of securities or other financialinstruments for hedging investment risk in actively, managed, exchangetraded funds includes a trusted computer system and a computer storagemedium. The computer storage medium stores a computer program productincluding instructions to extract factor information from a portfolio ofthe actively managed exchange traded fund, determine factors that affectthe price of the exchange traded fund and select a portfolio offinancial instruments with similar behavior with respect to thedetermined factors to produce a hedging portfolio that tracks the priceof the exchange traded fund.

One or more of the following advantages may be provided by one or moreaspects of the invention.

The specialist and market maker (each hereinafter referred to as“trader”) are provided with information that enables them to buy or sella specially constructed hedging portfolio that behaves in a very similarway to the underlying fund shares. The specialist and market makers areprovided with information that will be helpful in creating a hedgingportfolio to help them make markets with narrower spreads with goodcontrol of their risks.

BRIEF DESCRIPTION OF THE DRAWINGS

FIG. 1 is a block diagram of a computer system to perform an intra daynet asset value proxy calculation.

FIG. 2 is a flow chart showing a process to determine an intra-day netasset value proxy of an actively managed fund.

FIG. 3 is a flow chart showing a portfolio adjustment process.

FIG. 4 is a flow chart showing an embodiment of an intra-day valuationprocess for an actively managed fund.

FIG. 5 is a flow chart showing a process for producing a hedgingportfolio for an actively managed exchange traded fund.

FIG. 6 is a flow chart of an alternative hedging process for an activelymanaged exchange traded fund.

FIG. 7 is a flow chart showing an alternative process for producing ahedging portfolio for an actively managed exchange traded fund.

DETAILED DESCRIPTION

Referring now to FIG. 1, back room operations of an exchange 10, anelectronic market and so forth are shown. The operations 10 include acomputer system 11, which includes a CPU 12, main memory 14 andpersistent storage device 16 all coupled via a computer bus 18. Thecomputer system 11 may be a server as shown, which is coupled in anetwork of computers in a conventional manner such as in a client-serverarrangement. The details on the client server arrangement are notimportant to understand the present invention. The computer system 11can also include output devices (not shown) such as a display and aprinter, as well as input user interface devices (not shown) such as akeyboard and a mouse. The computer system 11 also includes a networkinterface 20, that couples the computer 11 to a network 24. The computerback room operation 10 also receives a quote feed from a quote server 26and portfolio information from a computer 28 associated with an activelymanaged fund.

The computer system 10 receives information concerning real-time pricesof securities from the quote server 26 and information concerningcomposition of portfolios from the fund computer 28. The computer system11 also includes intra-day NAV proxy algorithm software 40 thatcalculates in real time an intra-day net asset value proxy for anexchange traded fund, in particular for actively managed funds orenhanced index funds. Examples of other products that can use anintra-day NAV calculation can include the value of a spot commodity poolor futures pool; a basket of fixed income instruments chosen for theiryields, average maturities, specific durations, the currency in whichthey are denominated, or for other reasons or characterizations.

Referring now to FIG. 2, a process 40 to determine an intra-day netasset value proxy is shown. The process 40 can be used to calculate anintra-day NAV proxy for an actively managed portfolio or an enhancedindex fund over the course of a trading day. The calculation can beperformed in real time. The process 40 will be described in conjunctionwith an actively managed mutual fund. Once the closing portfolio isrevised for the day's transactions, or more accurately, the next day'sopening portfolio on which the intra-day NAV proxy and the officialclosing NAV will be calculated, has been determined and checked foraccuracy by the portfolio management organization, the portfolio isencrypted and transmitted to the intra-day price calculation (42).

The net asset value process 40 receives 42 in an encrypted format fromthe portfolio management organization. This portfolio information hasbeen adjusted to reflect any transactions made on the prior trading day(T−1). Official net asset value calculations that are disseminated tothe general media after the close of trading on a current trading day(T) are based on the position of the fund at the close of the priortrading day (T−1). The net asset value is calculated on current day (T)as if no trades occurred during the trading day. In general, thisconvention makes little difference in the overall net asset valuecalculation of the fund because it is unusual to have a combination ofmassive turnover on a single day and a significant difference in priceat which shares are sold on a current day and the closing price at whichthe fund is priced. The portfolio is also adjusted to take intoconsideration other factors such as dividend credits and expensesattributable to the current day (T). In other embodiments, the actualclosing trade date positions of the fund on the current day can be usedin the calculation.

The portfolio information is decrypted 44 and the information is used asthe template for intra-day calculations. As a check, a closing pricetape identical to the tape used in pricing the basket as of the previousnight's close, can be fed to the template to determine if the net assetvalue calculated against the template is identical to the previous day'sclosing NAV plus or minus known adjustments. The decrypted portfolio canbe re-encrypted using the same or a different encryption process andreturned to the portfolio management organization where it will again bedecrypted and compared with the file originally sent. This process isused to make sure that the file was not corrupted in the originalencryption and transmission process. Other checks are possible includingerror correction, unauthorized use detection, checksums, etc.

The portfolio information file is encrypted using a public encryptionkey of a public-private key encryption algorithm with the correspondingprivate key being only known by the net asset value proxy calculationprocess 40. The received portfolio data is decrypted in the net assetvalue proxy calculation process 40 using the corresponding private key.A portion 41 of the process 40 is executed within a so called “trustedsystem”. Trusted systems refer to a physical hardware and operatingsystem configuration in which domain configuration and trustrelationships are established to determine access to information on thecomputer 11.

A trusted computer can have the capability to recognize 25 anothertrusted system, to execute usage rights (in this case access rights forthe portfolio information file) and to render the file so that it cannotbe copied or sent in decrypted form outside of the process 40. A highlysecure channel can be established between the computer 11 and the fundcomputer 28 to enable a transaction where the two trusted systemsexchange data over a communication channel, e.g., the Internet or aproprietary network feed, providing assurances to the fund computer 28that it is in fact communicating with the exchange back room operationcomputer 11. Communications over a secure channel can be accomplishedwith encryption and what are known as challenge-response protocols.Other techniques are possible.

The computer system 11 would have a trusted relationship where a rightsor privileges policy is established such that the decrypted portfoliofile cannot leave the intra-day net asset value proxy process 40 in adecrypted form. That is, only the intra-day net asset value proxyprocess 40 itself is given privileges to access the data in the file andno copies can be made of the file. The file may reside in the systemthroughout trading until replaced with a new file for calculation ofintra-day net asset value on the next trading day (T+1). At that timethe file can be re-encrypted and returned to the actively managed fundor destroyed.

The process 40 matches 46 quotes from a quote feed to stocks in theportfolio throughout the current trading day (T). The process 40calculates 48 a new net asset value proxy for the fund by applyingreal-time quotes received from the quote server 26 to positions in thefund portfolio. The process 40 can disseminate 50 a net asset value forthe fund on a periodic or continual basis throughout the day.

Referring now to FIG. 3, a portfolio adjustment process 60 used toassemble a fund portfolio to send to the intra-day net asset valuecalculation process 40 is shown. Portfolio adjustment process 60 adjusts61 portfolio positions to take into consideration any trading thatoccurred on the previous trading day (T−1). These positions in theportfolio are further adjusted 62 for dividend credits attributable today (T), as well as adjusting 64 for any expenses attributable to day(T). Cash positions (not shown) are also taken into consideration. Theadjusted portfolio is assembled into a portfolio file and includesadditional information such as the total number of shares outstandingfor the fund or basket, e.g., to quote vendors, and so forth. Theportfolio file is encrypted 66 using the public key of thepublic-private key algorithm used in the process 40. The portfolio istransmitted 68 to the back room operations 10 of the exchange or marketwhere it is received 42 (FIG. 2) and used as described in conjunctionwith FIG. 2.

Referring now to FIG. 4, an embodiment of the intra-day valuation proxyprocess 40 for an actively managed fund is shown. The process 40decrypts 44 a the portfolio file, as received from the fund manager, andpopulates 44 b a table 44 c with fund positions. The table 44 c caninclude, for example, security symbols, quantity of shares held and anindication of whether the position in the shares is a “short” positionor a “long” position and so forth.

The process 43 continually receives 45 quotes or transaction prices fromthe trade and quote feeds and determines 46 whether a currently receivedsecurity and price corresponds to a security in table 44 c and thus is asecurity in the actively managed fund. If the security and price doesnot correspond to a security in the table, the process waits 47 toexamine the next new security and price. Otherwise, the process 40 willcalculate 48 a a new value of the position (and its bid and offer if theprice is a quote rather than a transaction price of the security) as ofthe trading day by, for example, retrieving the number of shares in theposition and multiplying the number of shares by the current quote forthe security. This new value will replace 48 b, a prior value for theposition in that security. The process 43 will calculate 48 c, a new netasset value proxy and/or new bid or offer of underlying instruments, bytaking the sum of the values of all current positions in the fund anddividing that by the total number of shares outstanding in the fund.

Another technique that can be used to calculate the net asset valueproxy would have the portfolio table 44 c include another field that hasthe value of the position on day (T−1). The table could also have atotal of all positions. The net asset value proxy calculation would takethe total valuation of the fund, subtract the old value of the positionfor a security and add the new value of the position for the securityinto the total. The new sum would be divided by the number ofoutstanding shares. The new, net asset value proxy calculation isdisseminated 50 through the exchange to quote vendors.

With this intra-day net asset valuation proxy process 40, a stockexchange can calculate in real time, intra-day net asset value proxiesfor actively managed and enhanced exchange traded funds. Portfoliomanagers are assured that the positions of the fund are not knownoutside of the fund so that others, e.g., traders and competitors willnot know what securities the fund is buying and selling. This isimportant to maintain a fiduciary duty to keep positions confidentialwhere confidentiality is in the interest of the shareholders of thefund. Thus, this technique assures confidentiality while enabling thesystem 10 and, the backroom computer 11, to give investors up-to-date,i.e., real time information on valuations to facilitate trading in themutual fund or trust instrument. Maintaining the confidentiality of thisknowledge is important because public dissemination of the informationmay enable individuals and organizations in effect to trade against thefund. This confidentiality is assured by encrypting the file and onlyproviding the software with the decryption key to decrypt the portfolioposition information in the file.

The portfolio information is only available to the net asset value proxycalculation internal to the computer. The information is eitherre-encrypted or destroyed so that unauthorized access is prevented. Thisprovides a process for determining an intra-day NAV proxy for activelymanaged or enhanced index funds that protects the information that thefund manager transmits to the intra-day NAV proxy calculation server.

A real time calculated net asset value proxy disseminated to the marketmay provide several advantages to the market. The real time calculatednet asset value proxy can help establish tight valuation ranges (e.g.,lower spreads between bid and ask) which may lead to tight pricing inmarkets for the basket of securities used to establish the funds. To theextent that trading in the basket would facilitate the formation of moreunits of the basket, i.e., creation of additional units of an exchangetraded fund or additional units of a commodity basket, etc., the cost ofmaintaining and operating the basket or portfolio would be spread over alarger pool of assets. Consequently, the costs per-dollar of assets inthe portfolio or basket might be reduced.

The backroom computer 11 on which the NAV calculation is performedshould have appropriate testing procedures for evidence of tamperingwith software, hardware or data files or access by unauthorized personsto provide a high degree of both physical and data security during theperiod the decrypted portfolio file is in use in the calculation ofintra-day Net Asset Value Proxies. The use of dual processors orsystems, for redundancy i.e., fault tolerance, would also beappropriate. In addition to improving reliability, a fault tolerantsystem can facilitate management of the system if there is a problem inthe calculation module. The ordinary steps that the management of asystem installation could take to repair a hardware or software problemmay be rendered more difficult by the encryption-decryption process andby the protections built into the processor. In other words, both thehardware and software may be less accessible than they would be in anormal installation.

Another aspect of the calculation is that it can provide in the contextof an actively managed fund bid and offer values and a spread in termsof the fund intra-day NAV proxy. While the calculation generally iscomparable in every material respect to the traditional 4:00 P.M. netasset value calculation, it may not be called a NAV calculation whendistributed to the market because of the issue of liability for any dataor calculation errors and because investors cannot necessarily buy orsell shares from the fund at that price. In addition, 4:00 P.M. closingprices are subject to verifications that may not be practical in anintra-day calculation.

The NAV proxy calculation could be used in a process to provide ahedging portfolio. Alternatively, the calculation used in a hedgingportfolio could be provided by the advisor, custodian, fund manager,etc. without encrypting or transmitting any data. Specialists and marketmakers manage their positions over the course of a trading day,generally to maintain either a market neutral or fund share risk neutralposition or a specific level of exposure that is independent of supplyand demand for the shares they are trading.

In the case of an index fund, the specialist or market maker that sellsshares to a public shareholder who comes to the market to buy may, atthe same time as the fund share sale occurs, buy stock index futurescontracts or an index equivalent basket of stocks or other instrumentsto maintain a consistent degree of exposure. However, an activelymanaged or enhanced index fund will not be as readily hedgeable using asingle benchmark index/stock index futures contract as an index fund andthe contents of the fund may be partly or completely unknown to thespecialist or market maker.

Referring to FIG. 5, in one embodiment, the specialist does not knowwhat is in the portfolio because the valuation is calculated fromencrypted data in the trusted system 41. A hedge creation process 80sends 82 the portfolio to another trusted process in the computer 11 orto another computer having a trusted process. In any event, the trustedprocess extracts 82 factor information from the portfolio and applies 84factor analysis to the extracted portfolio information.

Factor analysis, as described, for example, in the following papers: M.A. Berry, E. Brumeister and M. B. McElroy, “Sorting Out Risks UsingKnown APT Factors,” Financial Analysts Journal 44 (1988), 29–42; K. C.Chan, N. F. Chen and D. Hsieh, “An Exploratory Investigation of the FirmSize Effect,” Journal of Financial Economics 14 (1985), 451–471; B. A.Rosenberg, “Extra-Market Components of Covariance in Security Returns,”Journal of Financial and Quantitative Analysis 9 (1974), 263–274; S.Beckers, R. Grinold, A. Rudd and D. Stefek, “The Relative Importance ofCommon Factors Across the European Equity Markets,” Journal of Bankingand Finance 16 (1992), 75–97; J, K, Kale, N. H. Hakansson and W. G.Platt “Industry Factors versus Other Factors in Risk Prediction,”working paper, University of California, Berkeley (1991); E. F. Fama andK. R. French, “Common Risk Factors in the Returns of Stocks and Bonds,”Journal of Financial Economics 33 (1993), 3–56; B. Lehman and D. A.Modest “The Empirical Foundation of the Arbitrage Pricing Theory”Journal of Financial Economics 21 (1988), 213–254; and G. Connor and R.A. Korajczyk “A Test for the Number of Factors in an Approximate FactorModel”, Journal of Finance 48 (1993), 1263–1292, can be used to analyzehow various factors have an effect on pricing of the underlyingportfolio. These papers are incorporated herein by reference.

The factors that are examined by applying 84 factor analysis includefactors such as economic activity, inflation rates, industry membershipgrowth value linked behavior or other factors that are related tomeasures of security price behavior.

As an example, the specialist can be provided with a portfolio of e.g.,100 financial instruments and information of appropriate weightings ofeach of the instruments. Each of the 100 financial instruments will havedistinctive factor characteristics. That is, some of the financialinstruments are more interest sensitive, some are more inflationsensitive, some are more sensitive to industrial production, or to anyone of a number of other economic and financial market variables.

The process 80 constructs 86 a factor weighted portfolio by selectionand weighting those 100 instruments based on results of applying 86factor analysis. Ideally, the factor-based portfolio would be virtuallyidentical in market performance to the exchange traded fund. Theperformance expectation would be based on historic relationships, asanalyzed by the factor model. The specialist and market makers are givena list of instruments and the proportions of each instrument needed totake risk offsetting positions to hedge any long or short position theymay be called upon to take in the shares of the fund. The traders woulduse that information to create 88 a hedging portfolio.

While the hedging portfolio will not be identical in performance to thefund nor will it conform as closely to the fund performance as an indexbasket or instrument does with a fund based on an index, nevertheless,the hedging portfolio should track the exchange traded fund portfolioclosely enough over the course of a trading day or even a long period oftime to protect the trader from major losses. The hedging portfoliowould be updated daily to reflect changes in the composition of the fundportfolio. These hedging portfolios need to be liquid so that thespecialist can convert the position to cash or some particular portfolio(that can be used as a creation basket for the fund) at the end of theday.

The hedging portfolio can also be used to calculate a Net AssetValuation proxy much like that described above. However, rather thanusing actual positions in the exchange traded fund, the NAV process willuse the positions in the hedging portfolio and apply current prices tothose positions along with their weightings in the hedging portfolio todetermine a NAV proxy value. The hedging portfolio used need not beidentical to the actual hedge portfolio since the hedge portfolio mightnot take positions in certain securities since there might not be aliquid enough market for the security and so forth.

Referring to FIG. 6, a variation of the stand-alone hedging portfoliodescribed above is shown. This process 90 receives 91 an in-kindcreation basket that is posted or provided by the fund or instrumentthat the trader trades. The trader would produce 93 a supplementalhedging portfolio or basket as described above. The trader thus wouldinclude this supplementary hedging portfolio as an add-on portfolio tobe used in conjunction with the in-kind creation basket posted by thefund. In this case, the trader combines 95 a position in the creation(redemption) basket with a position in a supplementary hedge basket. Atsome point during trading, the trader could tender 97 (or receive) thecreation (redemption) basket to adjust its fund share position at theend of the day and close out the supplementary hedge portfolio at theclose.

To explain this process in more detail, a creation basket for anactively managed fund may not exactly match the portfolio and thus, itmay not be suitable as a stand-alone hedging basket. The creation basketmay be different from the fund portfolio to various degrees and, thus,the creation basket may not closely track the actively managed fund onan intra-day basis. Thus, rather than the specialist using the creationbasket alone as a hedging instrument, the trader could use the factorportfolio process described above or a combination of the creationbasket and the supplementary hedging basket produced by the factorportfolio process, because the trader may need a creation basket at theend of the day to exchange for the fund shares. The trader would need toclose out the supplementary hedging basket in a very low cost mannerperhaps using market-on-close-orders. This is another feature providedto traders for use in hedging their positions.

These features are designed to make markets tighter (i.e., lower spreadsbetween bid and asked prices) and to provide services which encouragepeople to list their funds on the exchange. To the extent that anintraday net asset value proxy is determined, it enables the specialistto know the appropriate price for shares that the specialist buys andsells over the course of the day. The investor can know that the marketis fair and that bid and offer prices tightly bracket the intraday netasset value proxy. The intraday NAV proxy process described aboveprocesses such data for an actively managed, exchange traded fund forwhich the actual positions in the fund are not known outside of the fundmanagement organization.

The hedging portfolio reduces the risk that the market maker orspecialist takes because there is a basket, that is the hedgingportfolio, that closely approximates the behavior of the exchange tradedfund on the long side of the market when the specialist shorts theshares or on the short side when the specialist sells the hedgingportfolio (short) to hedge a long position in the fund shares.

With this hedging portfolio, the exchange facilitates risk managementfor the specialist and replicates the risk as closely as possible to therisk that the trader is accepting. The hedging portfolio minimizes butdoes not eliminate tracking error. The hedging portfolio enables thespecialist or market maker to hedge its portfolio efficiently at a lowercost than they could do with no more than the fund's last reportedportfolio because that portfolio could easily be six months or more outof date.

The factor model provides the specialist or market maker with aportfolio of instruments, securities, etc. that will enable thespecialist to create a hedge that will track the basket of securitiesthat make up the exchange traded fund portfolio without the specialistever knowing what specific securities are in the fund.

The encrypted information is used to extract factors that affect thevalue of the securities that make up the exchange traded fund. The exactprocess will depend on the type of factor model used. Assume that aSharpe-type factor model is used. The Sharpe model will take an existingportfolio back in time (not the actual portfolio that was in the fund inthe past because the actual portfolio may change from day to day, butthe actual portfolio at the prior day's close as if that portfolio hadbeen in the fund all along).

Referring back to FIG. 5, the process 80 takes a potential hedgingportfolio of, e.g., 100 instruments, and executes a computer implementedmodel to determine weights, if any, in each of these instruments to givethe best possible tracking of the actual fund portfolio. The specialistor market maker who needs to hedge a position is provided with theappropriate weighted portfolio of instruments which would have trackedthat portfolio very closely or to a specific degree of tolerance ortracking error over the prior period. This information is used by thespecialist or market maker to produce a hedging portfolio to offset therisk of shorting the fund shares when there is more demand for the fundshares than the traders can supply from inventory, or going long thefund shares and short the hedging basket when there is less demand forfund shares and the traders must absorb fund shares into inventory.

Thus, the net asset value proxy calculation and the portfolio of hedginginstruments provide additional information for specialists and marketmakers on the floor to enable them to make better markets. While thisinformation may not be disseminated to market makers in other marketsdue to economic, regulatory and liability factors, the existence of theinformation should make these markets better (deeper and with a tighterspread) as well.

Unlike a synthetic hedging portfolio that is based on historical closingNAV while keeping the contents of the portfolio confidential, thehedging basket, to be effective, must be based on the current portfolio.In the synthetic hedging portfolio, only the closing NAV calculationsare used. Back over a period of time, these calculations become lessrelevant to the current contents of the portfolio. Furthermore, to theextent that the portfolio changes in a material way, net asset valuecalculations from even a few days earlier may give a misleading pictureof the investment characteristics of the portfolio.

Referring to FIG. 7, an alternative process 100 for a market maker orspecialist to hedge a portfolio is shown. The alternative processcalculates 102 an NAV history for the actual portfolio (as of theprevious day's close). The process 100 prepares and disseminates 104 ahedging portfolio for the use of the specialist, market makers and,perhaps, arbitrageurs interested in creating a hedging position. Theprocess 100 could be executed by the fund custodian or advisor or by theexchange using an encrypted portfolio much the same way that the NAVproxy calculation is determined. The process 100 would price thatportfolio using a price database. As long as the instruments to beevaluated and included in the recommended hedge and the technique usedare known in advance, it should be possible to reduce tracking error.The entity that prepares and disseminates the hedging portfolio reports106 a correlation or the tracking of the hedging portfolio with the fundportfolio. In order to determine tracking error, the entity needs actualknowledge of the portfolio as it exists at the previous night's close.

In general, such a hedging portfolio would be fairly constant, unlessand until there was a material change in the contents of the fundportfolio, at which time the hedging portfolio would probably change.Changes in the hedging portfolio could result from a broad change in theunderlying portfolio, e.g., a shift from technology stocks to financialstocks. Disseminating information on specific portfolio changes mightnot be acceptable to the advisor. Rather, the advisor may choose toaccept the cost of not providing a close tracking hedging portfolio,recognizing that the cost will include wider spreads and, probably, lessliquidity in fund shares in the market.

The hedging portfolio, a variation on full dissemination of theportfolio, will be acceptable to many fund advisors. A participant whowas considering creating or redeeming shares would look at a creation orredemption basket as part of the hedging position. The rationale for theredemption basket is that if the market maker or arbitrageur sought toredeem the basket, the portfolio he would receive would be for theredemption basket and would in many cases be different from the actualfund portfolio and from the creation basket. To the extent that thecreation or redemption basket does not match the fund portfolio, theadvisor or fund manager can add additional instruments (i.e., thesupplementary hedging basket to the creation or redemption basket) toimprove tracking. The additional instruments could be provided toimprove the tracking of the entire hedging position. The additionalinstruments could improve tracking for various market participants,particularly those engaged in arbitrage and market making, will helpimprove the quality of their hedges, and should have the highlybeneficial effect of reducing the bid-asked spread.

This alternative approach to producing a synthetic portfolio using afactor model or other technique has several advantages. The synthetichedging portfolio might include a mixture of futures contracts, optionsand/or a number of stock positions that collectively mirror the historicbehavior of the current portfolio. Using any of several types of factormodels, the buyer can develop a hedging portfolio that will be morehighly correlated with the fund than any single futures contract.

OTHER EMBODIMENTS

It is to be understood that while the invention has been described inconjunction with the detailed description thereof, the foregoingdescription is intended to illustrate and not limit the scope of theinvention, which is defined by the scope of the appended claims. Otheraspects, advantages, and modifications are within the scope of thefollowing claims.

1. A method of hedging investment risk in an actively managed exchangetraded fund, comprising; receiving or determining factor informationabout the actively managed exchange traded fund holdings, wherein one ormore computers programmed with factor analysis software determine thefactor information, which measures sensitivities of the fund holdings tofactors that affect the value of the fund holdings, and the factorinformation does not reveal the fund holdings; and using one or morecomputers with the factor information as an input to select a portfolioof financial instruments to produce a hedging portfolio withsubstantially the same sensitivities to the factors that affect thevalue of the fund holdings, wherein the specific securities in theactively managed exchange traded fund arc unknown to an entity who usesthe hedging portfolio to hedge against an investment in the activelymanaged exchange traded fund.
 2. The method of claim 1 wherein thehedging portfolio tracks the price of the fund.
 3. The method of claim 1further comprising: using the hedging portfolio to hedge a positiontaken in the exchange traded find.
 4. The method of claim 1 furthercomprising: applying factor analysis to the portfolio of the exchangetraded fund to determine the sensitivity of the fund to the factors. 5.The method of claim 3 wherein the applying step occurs in a trustedcomputer system.
 6. The method of claim 1 wherein the factors includeeconomic activity, inflation rates or other factors that are related tomeasures of economic activity.
 7. The method of claim 1 furthercomprising: selecting a group of securities, and constructing thehedging portfolio based upon weightings and selections of securitiesfrom the group of securities.
 8. A computer program product residing ona computer readable medium for hedging investment risk in activelymanaged exchange traded funds comprising instructions for causing acomputer to: receive or determine factor information about the activelymanaged exchange traded find holdings, wherein the factor informationmeasures sensitivities of the fund to factors that affect the price ofthe fund holdings and the factor information does not reveal the fundholdings; and select a portfolio of financial instruments to produce ahedging portfolio with substantially the same sensitivities to thefactors that affect the value of the fund holdings, wherein the specificsecurities in the actively managed exchange traded fund are unknown toan entity who uses the hedging portfolio to hedge against an investmentin the actively managed exchange traded fund.
 9. The computer programproduct of claim 8 wherein the hedging portfolio tracks the price of thefund.
 10. The computer program product of claim 8 further comprisinginstructions to: use the hedging portfolio to hedge a position taken inthe exchange traded find.
 11. The computer program product of claim 8further comprising instructions to: apply factor analysis to theexchange traded fund to determine the sensitivity of the fund holdingsto the factors.
 12. The computer program product of claim 11 wherein thefactor analysis is applied in a trusted computer system.
 13. Thecomputer program product of claim 8 wherein the factors include economicactivity, inflation rates or other factors that are related to measuresof economic activity.
 14. The computer program product of claim 8further comprising instructions to: select a group of securities, andconstruct the hedging portfolio based upon weightings of and selectionsfrom the group of securities.
 15. A computer system for producing ahedging portfolio for hedging investment risk in actively managedexchange traded finds, comprising: a trusted computer system; and acomputer storage medium storing a computer program product fordetermining the basket of instruments for hedging investment risk,comprising instructions for causing the computer to: receive ordetermine factor information about the actively managed exchange tradedfund holdings, wherein the factor information measures sensitivities ofthe fund holdings to factors that affect the price of the fund, and thefactor information does not reveal the fund holdings; and select aportfolio of financial instruments to produce a hedging portfolio withsubstantially the same sensitivities to the factors that affect thevalue of the fund, wherein the specific securities in the activelymanaged exchange traded fund are unknown to an entity who uses thehedging portfolio to hedge against an investment in the actively managedexchange traded fund.
 16. The system of claim 15 wherein the computerprogram further comprises instructions to: use the hedging portfolio tohedge a position taken in the exchange traded fund.
 17. The system ofclaim 15 further comprising instructions to: apply factor analysis tothe exchange traded fund to determine the sensitivity of the fundholdings to the factors.
 18. The system of claim 15 wherein the factorsinclude economic activity, inflation rates or other factors that arerelated to measures of economic activity.
 19. The system of claim 15wherein the computer program further comprises instructions to: select agroup of securities, and construct the hedging portfolio based uponweightings of and selections from the group of securities.
 20. A methodof calculating an intra-day value proxy for an actively managed exchangetraded find, comprising: producing a hedging portfolio to track anactively managed exchange traded fund by receiving or determining factorinformation about the fund holdings, wherein one or more computersprogrammed with factor analysis software determine the factorinformation, which measures sensitivities of the fund holdings tofactors that affect the price of the fund, and the factor informationdoes not reveal the fund holdings; using one or more computers with thefactor information as an input to select a portfolio of financialinstruments to produce a hedging portfolio with substantially the samesensitivities to the factors that affect the value of the fund; andapplying current prices to the hedging portfolio to determine theintra-day value proxy value for the exchange traded fund.